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Banking Is Slowly Getting Narrower — and Better


The US economy is now closer than it has ever been to realizing one of the more radical visions in the finance industry. Slowly but surely, through evolution rather than policy dictate, America is relying less on traditional banks — part of a reform known as “narrow banking.”

The basic idea is to separate lending and deposits: The banking system would hold very safe assets, such as government bonds, thereby limiting the risks from bank insolvency and bank runs, as well as the moral hazard from deposit insurance. Loans would be made by commercial credit lenders and other non-bank sources. Better maturity matching on the loan side would make the economy more resilient.

That’s mostly for the better, but the narrow banking model has long been plagued by two major problems. First, there have never been enough safe assets to satisfy the demands of depositors. Second, excessive investment in government securities tends to crowd out private investment. The rise of narrow banking can in part be explained by the mitigation of both these issues.

Unfortunately, the increased supply of US debt is mostly due to its deteriorating fiscal position. Currently the total stock of US government securities outstanding is a staggering $24.3 trillion, though not all of that is short term. The bright side is that asset holders have a greater number and variety of safe options.

The US is still not close to a point at which Treasury bills could serve as assets and liabilities for the entire banking system. Bank deposits amounted to about $17.5 trillion in March 2023, and government securities are needed for many purposes, such as fulfilling portfolio demand abroad and as collateral at clearinghouses.

Nonetheless, there is an ongoing shift of funds out of private banks and into money market funds. Much of the change comes from fears about the solvency of regional banks and uncertainty about how far deposit insurance guarantees will extend. Money-market funds are a safe bet, and they can be used to write checks. So at the margin there is more narrow banking, even though narrow banking is unlikely ever to swallow the entire financial system.

Another factor in favor of the growth of narrow banking is that the current system of US deposit insurance appears less and less workable. In some regional banks, over 90% of the held deposits are above the Federal Deposit Insurance Corp. limit. Yet when the value of those deposits comes under question, the FDIC (often in conjunction with the Federal Reserve and the Treasury Department) finds itself stepping in and guaranteeing those deposits anyway, for fear of a bank run.

When all deposits are de facto guaranteed, a bank’s incentive to take risk increases. Perhaps today this dynamic is at a breaking point, and so a marginal increase in narrow banking could be a way of injecting more safety into the payments system.

The shifting of private funds into Treasury bills could be problematic if that meant credit to the private sector was shrinking. But the rise of private equity and other forms of non-bank finance has made that less of a concern. While private equity growth has slowed since the second half of 2022, it has been on a steady rise since the financial crisis.

Private equity allows many new ventures to be financed, and a run on private equity firms is difficult to pull off, since they are not funding themselves by issuing liquid demand deposits. A private equity venture has a much greater ability to withstand swings in the market. By one metric, private equity measures at almost $12 trillion in value as of mid-2022 — another sign of the US economy advancing in its tools of financial intermediation.

These are not pure market developments, as they are partly a response to the growing regulatory burden on banks, most of all capital requirements. Again, the current regulatory dynamic is not entirely stable. Unstable banks do create trouble, and in return higher legal and regulatory burdens are placed on them, thereby diminishing their profitability. The cycle continues, and implementing tougher regulations hastens the changes rather than halting them.

The marginal switch into more narrow banking is itself an imperfect alternative, as non-bank lenders are not riskless (nor, these days, are government securities). Nevertheless the rise of narrow banking is a reality, and while we should recognize its weaknesses, we should not lose sight of its considerable virtues.

Elsewhere in Bloomberg Opinion:

• Banking Gets a Bit Narrower: Matt Levine

• The Only Way to Stop Bank Runs Is to Get Rid of Banks: Paul J. Davies

• Insurance for All Bank Deposits Is a Manageable Cost: Karl Smith

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This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Tyler Cowen is a Bloomberg Opinion columnist. He is a professor of economics at George Mason University and writes for the blog Marginal Revolution. He is coauthor of “Talent: How to Identify Energizers, Creatives, and Winners Around the World.”

More stories like this are available on bloomberg.com/opinion

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